A Free Market In Chains

If left to its own devices, a truly free market would have already corrected many of the imbalances of the late, great credit bubble. Instead, US policymakers at the Federal Reserve and the Treasury Department have been trying to re-inflate the credit bubble by pumping trillions of dollars of fresh credit and currency into the financial system. The Fed is still maintaining these Keynesian tactics, despite the increasing possibility that inflation and other adverse outcomes will result.

Kansas City Fed President Thomas Hoenig is one of the few policymakers who appear to grasp the following simple economic truism: There is no free lunch. In his April 7 speech “What About Zero?” Hoenig says, “Low rates, over time, systematically contribute to the buildup of financial imbalances by leading banks and investors to search for yield.” In other words, Hoenig doesn’t want to be complicit in the ZIRP (zero interest rate policy) experiment the Fed is currently conducting.

“The search for yield involves investing in less-liquid assets and using short-term sources of funds to invest in long-term assets, which are necessarily riskier,” Hoenig continues. “Together, these forces lead banks and investors to take on additional risk, increase leverage, and, in time, bring in growing imbalances, perhaps a bubble and a financial collapse.”

Hoenig has the courage to speak up about long-term consequences. This is a refreshing contrast to what passes for judgment among other Fed governors, whose votes reflect short-term thinking and ignorance of the long-term consequence of ZIRP.

The rest of the Fed’s academics point to the alleged benefits of zero interest rates and deficit spending, while remaining either blissfully unaware of – or intellectually dishonest about – the unseen costs of these policies. A good example of this myopia was on display when Alan Greenspan testified in front of Congress last week. Even after the 2008 crisis, Greenspan still refuses to acknowledge the destructive economic distortions that his Fed policies nurtured.

The unseen costs of “easy money” policies are hard to identify or measure, but that doesn’t mean they don’t exist. By definition, the Federal Reserve is giving a subsidy to someone anytime it provides credit that costs less than the private-market cost of capital. And, by definition, a subsidy is an expense that someone else must bear.

In today’s post-crisis economic environment, the Fed’s ZIRP policy provides a very direct and obvious subsidy to the nation’s largest financial firms. These firms borrow from the government at low rates of interest, then loan the money back to the government at much higher rates of interest. In the first instance, only a handful of privileged financial firms may borrow money from the government at low, preferential interest rates. But in the second instance, we, the taxpayers, must bear the cost of the high rates of interest the government pays back to the financial firms.

Meanwhile, in order to fund our growing national deficits – which are caused partly by the subsidies our government provides – political leaders in the US are making up for the lack of domestic savings by importing the excess savings of the rest of the world. Foreign creditors are financing our deficit-spending by buying Treasuries. But global savings don’t come free; they come in exchange for claims on the future productive capacity of the US economy. The US is selling claims on its assets in exchange for propping up an unsustainable status quo.

Academic economists come up with overly simplistic reasons why this process can continue indefinitely, including the old standby, “Japan has done it for 20 years, and its bond market yields are still low.” Not all countries have the productive captivity and competitiveness that Japan has. Greece does not, and its government debt hasn’t turned out to be sustainable.

China has its problems and bubbles, but at least its government’s make- work projects are adding to the productive capacity of its economy (physical and intellectual capital that will exist, even after the world abandons its unworkable currency and government debt systems).

In China, politicians try to do everything they can to promote economic growth that adds to its productive base. In the US, politicians are doing everything they can to redistribute wealth, no matter the economic consequences. And all the while, the line of phony capitalists seeking subsidies in Washington, DC is growing longer. The more corporate subsidies the US government hands out – whether it be to banks, health insurance companies, or auto makers – the faster the government undermines its own creditworthiness.

Treasury yields could rise sooner than most investors expect. Not because of inflationary pressures, or because of the Fed hiking rates, but because of the simple mechanics of overwhelming Treasury supply and falling creditworthiness. Bond investors know that a surging supply of Treasury securities is on the way. So these investors might become much less eager to pay high prices (low yields) at future bond auctions.

In short, the federal government’s eyes have become much bigger than the taxpayers’ stomach. The illusion that the US government has unlimited resources will come to a painful and decisive end in the form of higher Treasury yields…and much lower profitability in the US financial sector.

Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

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